Swedroe: The Problem(s) With Hedge Funds

In 1990, hedge funds managed approximately $39 billion in assets. Current estimates put hedge fund assets at $2.5 trillion. That miraculous growth, especially in light of the very poor overall performance of the industry, highlights the need for investors to be able to make informed decisions.

This is especially true because most hedge funds also offer more complex risk exposures to factors that determine returns, and can expose investors to greater risks of “black swan” or tail events, illiquidity and valuation uncertainty.

Mila Getmansky, Peter Lee and Andrew Lo, authors of the July 2015 paper, “Hedge Funds: A Dynamic Industry In Transition,” provide a great service by summarizing the academic literature on the industry. The paper, at more than 100 pages, is the most detailed survey I’ve read, and is highly recommended for both practitioners and investors interested in this subject. Following are a few important highlights.

Biases in the Data

There are a number of biases that may arise among hedge-fund returns databases that are not present in other asset-pricing databases in which all securities of a given type are included (e.g., the University of Chicago’s Center for Research in Security Prices (CRSP) stock returns database).

Among them are self-selection bias, backfill (or instant history) bias, survivorship bias, liquidation bias and data revisions (this is from a new paper, “Change You Can Believe In? Hedge Fund Data Revisions,” which appears in the June 2015 Journal of Finance).

Risk Of Dying

Approximately 30 percent of new hedge funds don’t make it past 36 months due to poor performance. Almost half of all hedge funds never reach their fifth anniversary. And only about 40 percent survive for seven years or longer.

The risk of dying is so great that in 2014, the attrition rate rose to an unprecedented 26 percent. The authors suggest that either the number of hedge funds is declining (the competition has gotten too great to allow for excess profits, or alpha), or that fewer hedge funds are choosing to report their returns to the commercial databases.